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May 4, 2012

Five Good Questions for Tadas Viskanta of Abnormal Returns

The author says that active investors need to be aware that the odds are against them and that there are real costs, both explicit and implicit, in taking such an active approach

Tadas Viskanta (left) is the founder and editor of the indispensable investment blog, Abnormal Returns. Over its six-year life, Abnormal Returns has become a fixture in the financial blogosphere.

Over thousands of posts Tadas has brought the best of the financial blogosphere to readers. He is a private investor with over 20 years of experience in the financial markets.

Tadas (right) holds a MBA from the University of Chicago and a BA from Indiana University. He lives with his family in the heartland of America. He has graciously agreed to answer what I hope are Five Good Questions.

1. Your book – rightly I think – describes investing as the “last liberal art” since what is interesting in investing isn’t really captured by the data. How then do you suggest using the data we have and integrating it into the liberal art of investing?

We are awash in data. You could even say we are in a bull market for economic and financial indicators. It seems like every week there is a brand new indicator that will purportedly help us better understand the economic world around us. Despite all of this information I would argue that the vast majority of investors are not rigorous enough in their use of data.

Most investors rather than using a structured approach to stock selection and portfolio construction are really flying by the seat of their pants. This ad hoc approach leads to all manner of bad behaviors including overtrading and underdiversification. That is why client portfolios often look like a mish mash of stocks and funds than a consciously chosen strategy.

Unfortunately the data don’t often tell us the whole story. Every investor whether their approach be fundamental, technical or quantitative is going to have a period in which they underperform. The question is then asked: Is it different this time? Is my model/worldview broken? Most of the time with a well-constructed strategy it makes sense to stay the course.

However, sometimes the world really does change, oftentimes abruptly. If anything you could argue that these trend breaks are more likely now than ever before due to technology. Identifying these disruptive periods require a grounding not only in finance, accounting and economics but also in history, technology, politics and psychology to name but a few.

2. The book focuses on an investor’s need for humility since we can so easily go “off the rails.” What techniques or devices do you use to try to guard against errors?

Most investors would claim that their time horizons are in the decades if not years, let alone months, weeks or years. If that is the case then are they spending their time watching CNBC and trying to trade during the day?

Their time would be much better spent reading, doing analysis and thinking than worrying about the minute-to-minute gyrations of the market. There are very few people are able to make money in that time frame especially as high frequency trading now dominates intraday trading.

What matters often is not the news itself, but the market’s reaction to the news. That requires more perspective than you are going to get from the financial media. If there really is no good way to limit your consumption of the media then you really have to block it out entirely and focus on what matters. Your intraday decisions are more likely to hurt than help over the long run.

3. Following John Bogle and holding a portfolio of exceedingly broadly diversified index funds essentially forever would fit with your suggestion that investors avoid the active management game and keep things simple. Are you a total buyer of the concept?

Up to a point. I think for the vast majority of investors a broadly diversified portfolio of index funds, rebalanced regularly with an eye on taxes and expenses should be their default approach. Two things are important to note.

Active strategies whether they are stock selection, market timing or manager selection are costly. Whether you do it yourself or hire a manger these strategies increase your expenses with no guarantee that they will necessarily increase your returns for the risk taken.

Not only is there an explicit cost there is also an opportunity cost. The time and effort put into trying to generate additional returns could be spent in other ways.

These don’t necessarily have to do with investing. Most investors don’t have the burning desire to be active portfolio managers. Their time would be better spent on their careers or family rather than in the pursuit of a few more basis points of returns.

4. You extol the virtue of “investment mediocrity” in your book. When, if ever, should we strive to do better than that?

I say in that book that investment mediocrity or competence is not too low a hurdle. John Bogle has written extensively about how it is that a low-cost indexed approach to investing will actually lead to above-average returns. This occurs by simply avoiding the high-cost, active game that most everyone else is playing.

This doesn’t exclude the possibility of finding managers that can outperform. The challenge is identifying them ahead of time and hoping that their alpha will outweigh whatever fees they charge. I talk about in the book the difference between luck and skill in investing. Unfortunately there is no easy way of teasing out these two effects.

Investing is one of those rare endeavors where amateurs can compete directly with professionals. That is an enticing prospect. Investors just need to be aware that the odds are against them and that there are real costs, both explicit and implicit, in taking on an active approach.

All that being said I don’t think I or anyone else should dissuade a highly motivated investor from undertaking active strategies. No one can say ahead of time who will or will not be successful. It requires actually doing it and getting your hands dirty. However, investors need to undertake active strategies, like they would any other business endeavor, with rigor and above all a focus on risk.

5. What is the best piece of investment advice you ever received?

“There is no must-own stock/fund/asset class, etc.”

This kind of thinking leads investors to load up on Internet stocks in 1999 and second homes in 2006. Investors are easily caught up the waves of sentiment that drive markets. We are driven to own a certain asset lest we feel like we are missing out some once in a lifetime opportunity. This peer pressure leads us to make decisions that ultimately work against our own best interests.

Every investor is ultimately his or her own client. You have only to answer to yourself and your own goals. You have to feel comfortable and confident with your decisions and you shouldn’t feel that you have to do something because everyone else is doing it. This ultimately leads to a real disconnect between the risk we think we can take and actual risks we are taking.

This dissonance in risk perception in theory and in practice is what leads to investors reducing risk at market bottoms and increasing risk at market tops. This so-called “behavior gap” drives a wedge between the returns we can earn and what we ultimately earn. In today’s markets there just isn’t that much in the way of nominal returns where we can afford to lose much to our own unforced errors.